RBI Cracks Down on Derivative Trading Practices: Is IndusInd Bank Fiasco just the Tip of the Iceberg?

RBI Launches Bank-Wide Review of Risky Trades after IndusInd Bank fiasco 

The Reserve Bank of India (RBI), India's central bank, has launched a sweeping review of derivative portfolios across both private and state-owned banks. This move comes in the wake of discrepancies discovered in IndusInd Bank's accounting related to foreign exchange derivatives, raising concerns about potential widespread non-compliance with regulations.

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Sources familiar with the matter, speaking on condition of anonymity, confirmed that the RBI has contacted banks to assess their hedging positions and gather details on their derivative trades. The regulator's initiative has two primary objectives:

• Checking for Wider Compliance Issues: The RBI wants to determine if other banks are also failing to adhere to the recently updated rules on derivative trading.

• Assessing Treasury Compliance: This review provides an opportunity for the RBI to evaluate the overall internal controls and risk management practices within banks' treasury operations.

The Rules of the Game:

The RBI's "Master Direction- Classification, Valuation and Operation of Investment Portfolio of Commercial Banks (Directions), 2023" requires banks to categorize their derivatives into three "fair value hierarchies" (Level 1, Level 2, and Level 3) and disclose these in their financial statements. Crucially, banks are prohibited from paying dividends based on unrealized gains from Level 3 derivatives (the most complex and difficult-to-value instruments). These unrealized gains must also be deducted from the bank's core capital (CET 1). These regulations are designed to promote transparency, strengthen risk management, and encourage the development of the corporate bond market.

On the currency derivative front, a January 5, 2024 circular from the RBI stipulated that investors must have a "valid underlying contracted exposure" when engaging in currency derivative trades. This means they can't simply speculate on currency movements; they must have a genuine business need to hedge against currency risk. This rule led to a decrease in open interest in currency derivatives on the National Stock Exchange.

The IndusInd Bank Trigger:

The catalyst for this industry-wide review was IndusInd Bank's recent disclosure. On March 10th, the bank revealed in an exchange filing that an internal review had uncovered discrepancies in its derivative portfolio, potentially impacting its net worth by 2.35% (out of approximately ₹62,000 crore as of March 31, 2024). This could translate to a profit hit of around ₹1,500 crore, although the final amount could be higher pending an external review.

The review of the bank's investment portfolio was ordered by the RBI in September 2023.

IndusInd Bank's CEO, Sumant Kathpalia, disclosed the discrepancies in a late-evening conference call but didn't elaborate on how they were discovered. The following day, the bank's stock price plummeted by over 27%. Chairman Ashok Hinduja subsequently sought to reassure investors, pledging full support and potential capital infusion if needed.

As of March 12th, the stock had recovered slightly, trading up 3.7% on the National Stock Exchange, breaking a five-day losing streak. The RBI's swift action underscores its commitment to maintaining financial stability and ensuring that banks adhere to regulations. This review is likely to put pressure on banks to tighten their internal controls and risk management practices related to derivative trading.